What is a dividend and how does it work?

It might be helpful to think of dividends like slices of a single pie. When investors buy shares of stock in a company, each share is equal to a sliver of the pie. And when the company earns a profit, it typically pays dividends to everyone with a slice.

The more slices of pie—or stock—an investor owns, the more they typically receive in dividends. But there’s plenty more to it.

Key takeaways

• A dividend is a company’s payment, based on profit, to the people who own stock in the company.
• Dividend payments are based on the class of the stock, the stock price and the number of shares an investor has in a company.
• Dividends are frequently paid in cash to investors but may come in other forms of compensation.
• Stockholders must own stock before the ex-dividend date to receive a payment for that period.

A dividend is money investors receive for a share of stock when a company is profitable for a set period. The compensation is divided between all the stocks, based on the ownership class of stock. Stocks may be classified as preferred or common stock. Dividends are divided evenly within each classification.

For tax purposes, the dividends an investor receives are typically considered taxable income. But if it meets the requirements to be a qualified dividend, the dividend amount is taxed at the capital gains tax rate.

When you divide a company’s net profit by the number of common shares, you get the earnings per share (EPS). This number is often used to show a company’s profitability.

What is a dividend yield?

A dividend yield is a ratio of the dividends paid out by a company compared to its stock price. Typically expressed as a percentage, this figure provides potential investors with an idea of how much money they may earn on a stock relative to its price. It’s calculated based on a company’s previous annual financial reporting, typically from either the past calendar year or the past four quarters.

While the estimate can be helpful for some investors to understand how much they can earn from a stock, it’s not a complete picture of the value of a company. For example, companies with falling stock prices may have high dividend yields, but that may not make them sound investments.

Preferred stock vs. common stock

The class of a stock affects the rights a shareholder has and how they’re paid dividends. Preferred stockholders have less say in the operation of a company. But they have more rights to receive dividends than common stockholders do.

Investors with preferred stock receive dividends at a fixed rate and must receive all their dividends before common stockholders. If a company’s profits are less than what it owes its preferred stockholders, the debt will carry over to the next dividend payment period. On the other hand, investors with common stock may be able to vote at stockholder meetings, while preferred stockholders usually don’t have voting rights.

While any stock could pay dividends if a company is profitable, not all companies pay dividends at the same frequency or in the same way. It may depend on the type of stock.

• Income stock: Also called dividend stock, this type regularly pays investors dividends on the profits that the company has earned. This can be quarterly, annually or on any schedule set by the board of directors for the company.
• Growth stock: Doesn’t regularly pay out dividends to shareholders. Instead, the value for investors is the capital appreciation of the stock itself. This is most commonly found with companies that are growing rapidly.

How dividends are paid

While it’s common to pay dividends in cash, it isn’t a strict requirement. Companies can also pay dividends in the form of:

• Stock in another company
• Payment of shareholder’s debt
• Use of company property or other services

Dividends vs. share buybacks

While a company can pay shareholders through dividends, share buybacks are another way for companies to add value for shareholders. A share buyback occurs when a company purchases shares of its own stock that are available on the stock market.

As buybacks lead to fewer outstanding shares on the market, shareholders receive more money for each of their shares. It’s a way to boost investors’ earnings without paying out dividends directly.

Dividends are paid when the board of directors of a company agrees to release profit to shareholders instead of reinvesting it in the business. Many companies pay quarterly dividends, but others may pay annual or monthly dividends.

Once a decision has been made to pay dividends, there’s a set time frame for when the dividends will be paid out and which shareholders will receive a payment.

1. A company will have a declaration date, which is the day the company announces when a dividend will be paid out.
2. An ex-dividend date is set at this time, which marks the cutoff for when a share may be purchased that would be eligible for a dividend. Shares bought on or after the ex-dividend day aren’t eligible for that scheduled dividend.
3. The business day after the ex-dividend date is the record date, when the company records the shareholders who are eligible to receive the dividend.
4. The payable date is the payment date when eligible shareholders will receive their dividends.

Not all dividends are recurring

When a dividend is set by a company, it’s typically set as a recurring payment. But some dividends may come at different times or may greatly exceed other recent dividends and earnings—often as a result of structural changes to a company. In these cases, the payment is considered a special dividend.

A dividend is the compensation based on a company’s profit that investors receive for the stock they hold in a company. An investor’s dividend payment might depend on the type of stock, the price of the stock and how many shares they hold when the dividend is set to be paid. Whether it’s a regularly occurring payment or a special dividend, the timing of dividend payments is set by the company’s board.

If you’re interested in understanding more about investing, check out this guide on how stocks work.